Supply chains after the pandemic: transformation or business as usual?

The COVID-19 crisis revealed the vulnerabilities of global supply chains. In response, companies and governments developed plans to mitigate these vulnerabilities. Thijs Knaap, Chief Economist at APG, discusses whether significant changes have indeed occurred in global supply chains or if the benefits of long supply lines still outweigh the drawbacks. "It turns out to be very difficult to completely reroute existing trade flows."

Over the past decades, many companies relocated their production facilities from the West to low-wage countries, a trend that accelerated after China joined the WTO in 2001. China's accession had multiple advantages, Knaap explains. “With the elimination of import tariffs, Chinese exporters, who were already trading with the West, became cheaper. Additionally, after China’s WTO accession, many new Chinese suppliers emerged. This meant Western companies had to compete with their Chinese counterparts, thereby reducing their prices. Adding it all up, the prices of manufactured goods fell by about 8% between 2000 and 2006. That’s quite significant, especially considering that prices usually only rise.” This trend continued until around 2016, when factors such as Donald Trump’s election, changes in China’s economy, and Brexit led to slower growth in global trade.

Four disadvantages of globalization

This brings us to the disadvantages of globalization, of which Knaap identifies at least four. “The first is the vulnerability of long supply chains. Goods must be shipped, and that doesn’t always go smoothly. Think, for example, of the ship that blocked the Suez Canal for a week in 2021, or more recently, the Houthi rebels attacking cargo ships with missiles and drones from Yemen. These incidents cause delays. The COVID-19 pandemic also disrupted international trade through factory closures in hard-hit areas, a shortage of available shipping containers, associated price increases, and sudden fluctuations in supply and demand in certain sectors.”

A second disadvantage is what economists call structural change. “An example is the relocation of jobs to low-wage countries. A consequence of this is increased unemployment where the jobs used to be, especially in the manufacturing sector in Western countries, such as the Rust Belt in the US, along with all the associated socioeconomic problems. Additionally, the disappearance of knowledge is a problem. If a country outsources a production process, such as for cars or weapons, it cannot simply retrieve that knowledge. This leads to stagnation in innovation. National security risks are the fourth disadvantage of globalization. When trading with other countries, you can never be sure how the goods you export will be used. Conversely, there is the risk of becoming dependent on a product or raw material from another country. Several European countries, for instance, were dependent on Russian gas when Russia invaded Ukraine and the EU imposed sanctions on trade with Russia.”

Deglobalization is not progressing

Can these disadvantages be mitigated? “Bringing production back from low-wage countries makes goods much more expensive again, so it doesn’t happen automatically. A country can reduce the price difference by imposing import tariffs, as the US and EU do on products from China. This can positively impact employment if, for example, a car factory relocates its production to the US or EU, but it will negatively affect consumer purchasing power. Wages in the West are higher than in China or low-wage countries. Alternatively, a country can subsidize its own production, but those subsidies are ultimately paid for with tax money, so consumers feel it in their pockets. Higher costs hinder the attractiveness of local products, which can be an environmentally friendly option but will often be more expensive than products from countries with lower wages. A middle ground is formed by friendshoring or nearshoring: not bringing production back to the home country, but to friendly countries nearby where wages are still relatively low. But as they develop, those countries are also becoming more expensive.”

Globalizing trade was easy, but deglobalizing to some extent is proving difficult, Knaap states. The COVID-19 pandemic put countries and companies on the path to reducing supply chain vulnerabilities by seeking multiple suppliers. “But that only helps with the vulnerability of supply chains, and not, or only to a limited extent, with structural change, the loss of knowledge, or national security risks.”

One of the few recent studies on changes in global supply chains shows that the US has increased its imports since 2017. “In that sense, there seems to be no deglobalization. In 2022, the US even reached an absolute peak in imports. However, the share of Chinese goods in total US imports has decreased by 5 percentage points. This is compensated by imports from countries like Mexico and Vietnam. However, these countries also import a lot from China, so trade flows are only partially rerouted. This effect is caused by import tariffs and restrictions. Tariffs can theoretically be absorbed by the producer, but more often such a tariff is passed on in the product price, so it’s the consumer who pays the cost. That’s what happened in the US. And producers adapt: In Europe, due to import tariffs on Chinese electric cars, they now come from assembly factories, often Chinese-owned, in countries like Hungary.”

Economic Fragmentation

Looking at the numbers, two further trends emerge. “The first is that global trade grew by 7.5% annually at the beginning of this century. Now it’s about 1.5%. But while the US continues to import more, that growth in the EU is flattening. This could be due to production being relocated to the EU, but also because the EU is growing less rapidly than the US. The second trend is economic fragmentation. The IMF examined countries’ voting behavior in the UN regarding resolutions on the war in Ukraine. Countries that vote the same way are considered friendly nations. Trade between them still grows by 3% per year, but trade between non-friendly nations no longer grows.”

Zooming in on this economic fragmentation shows that while trade between non-friendly nations no longer grows, it’s also not declining. Knaap: “Behind this lies the fact that much production has been relocated to low-wage countries for a reason. Their low production costs and enormous production capacity are simply too important.” The trend of increasing trade continues, albeit to a lesser extent, Knaap concludes. “This seems contradictory to the amount of media attention for all trade restrictions, but perception and reality can differ. Brexit is a good example. The British thought that by leaving the EU, they would ‘take back control.’ They didn’t seem to realize that the daily flow of goods and services between the UK and the EU depended on their EU membership. And for both economies, this flow is extremely important. In this way, Brexit shows on a small scale what is happening on a large scale between the major trading blocs of the US, EU, and China. Ultimately, it turns out to be very difficult to completely reroute existing trade flows.”